Seller’s Option
An option that allows the seller flexibility in setting the specifications of a commodity to be delivered
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What is Seller’s Option?
Seller’s option is a settlement option that allows a seller to set the timelines for the delivery of the underlying asset and determine when the final settlement will occur. Such a type of settlement option is available in forward contracts. It allows the seller some leeway in the specifications of a contract, such as the delivery date and delivery location.
The seller’s option is used when the contract involves the delivery of physical goods. The seller does not need to worry about meeting the rigid specifications provided in the standardized contract. A seller can exercise the option if they encounter difficulties in making delivery of the commodity or other underlying asset at the specified time.
The farthest possible delivery date is usually specified in the standardized contract. It allows the seller to delay the delivery or settlement of the contract beyond the stated delivery date but before the farthest possible settlement date.
Summary
- A seller’s option is an option that allows the seller flexibility in setting the specifications of a commodity to be delivered.
- Seller’s options are commonly used for making physical delivery of commodities without worrying about the predetermined specifications of a standardized contract.
- The seller’s option allows the seller to delay the settlement or delivery date beyond the normal time provided in the standard contract.
Understanding Seller’s Option
Seller’s options are employed in forward contracts involving physical products, such as oil, rice, natural gas, and grains. Collecting sufficient volumes of the commodities and transporting them to the specified delivery location can be an expensive and complicated process.
If the seller takes physical possession of the commodity and faces difficulties in meeting the delivery schedule, he/she may require additional time to deliver the commodity and complete the transaction.
Therefore, the seller may request the other party be executed on a seller’s option basis, allowing the extension of the delivery schedule to an agreed future date. The buying party must consent to the new requirements for adjustments of the settlement terms before the seller can adopt the new terms.
For example, a forward contract may require the delivery of 10,000 barrels of oil within 100 days at $640,000. The contract may require the forward contract seller to deliver thousands of barrels of oil in a single delivery window to the specified location. Due to the delicate nature of transporting oil, the seller may require a bit of flexibility in the contract to eliminate any challenges that may be encountered in meeting the terms of the contract.
The seller may request to deliver the oil in two shipments within 150 days. The seller must ensure that the product quality and delivery specification comply with the contract’s pre-established specifications. By requesting that the contract be executed on a seller’s option basis, the forward contract seller will deliver the goods without worrying about the delivery date or settlement date.
Seller’s Option in Bond Futures
Seller’s options may also be included in bond futures with cheapest to deliver (CTD) contracts. The contracts refer to the cheapest security that a seller can deliver to a long position to meet the futures contract specifications. Such terms may only work if the contract approves the delivery of slightly different securities from what was initially prescribed.
Where there are multiple financial instruments that meet the contract terms, the seller should identify the instrument that will be the cheapest to deliver. The seller can pick the instrument that maximizes their profit without compromising on the quality of the asset. The seller, who holds a short position, sells the financial instrument with the intention of repurchasing it at a lower price in the future.
Examples of an asset that may employ CTD contracts is Treasury bond futures contracts. The contracts require that the seller deliver any qualified Treasury bond to meet the terms of the futures contract on the condition that the bond is within a predetermined maturity range and with a specific coupon rate.
Basics of Put Options
The term “seller’s option” may be used to refer to a put option because the put owner owns the right to sell a specific amount of the underlying asset at a set price and within a specific time. Usually, put options may be traded on different underlying assets – currencies, commodities, stocks, and indexes.
The put option holder can sell the underlying asset – such as stock or currency – at the strike price before the expiration date. The buyer believes that the underlying asset will fall in value before the exercise price and before the set expiration date.
In such a case, the exercise price refers to the price that the underlying asset must attain for the contract to hold value. Investors use put options as a risk management strategy to ensure that the losses in the price of the underlying asset do not fall below the strike price.
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